Published 7:00 pm, Saturday, July 11, 2009

Over the past couple of decades, the financial services industry and the environment in which it operates has experienced a sea of changes. Globalization has become a predominant characteristic of the economic way of life. Business activities on an international level have impacted financial operations the world over, and with it the lives of the citizens of numerous countries. Complex financial instruments have also made the system virtually incomprehensible to the uninitiated.

Until about a decade ago, the U.S. regulatory approach was highly restrictive and harkened back to the philosophies that grew out of the Great Depression. These mechanisms were much too confining for the emerging realities of world commerce, and limited the capacity of the U.S. to function as the top economic power. Much needed reforms that opened up the system were enacted in 1999, but did not include sufficient safeguards regarding exotic new funding mechanisms.

President Obama took an initial step toward regulatory reform by making several recommendations to accomplish what some call bringing America's financial institutions into the 21st century (though others apply less positive descriptions). If adopted, his proposals will impact banks, hedge funds, investment banks, and various other aspects of the financial services industry. They will also seek to rein in the abuses in various securities that contributed to the recent debacle.

As is well known, the financial services sector enables and facilitates economic expansion through the allocation of capital. While this process is essential and generally works quite well, it is easy for short-term incentives to drive behavior that is counterproductive and potentially (as we have recently seen) disastrous. To prevent such adverse outcomes, some level of supervision is required.

The nation's financial services' regulatory system normally controls activities according to function. This approach is designed to enable overall consistency but does not require agencies charged with oversight to have expertise in every aspect of financial regulation. Formal and informal communications systems operate between the entities, but even so, they sometimes do not produce sufficient rules and policies to ensure proper functioning.

According to the President, such a process, as well as the lack of crises resulting from positive growth over the past several years, has led to complacency. This situation, coupled with the burden recently placed on the shoulders of the American public as a result of rising unemployment, business downturns, and housing and credit difficulties, as well as myriad other challenges, has required an assessment through new eyes.

The President has made recommendations that purport to establish comprehensive regulation of financial firms, protect consumers and investors from financial abuse, provide the government with tools to manage financial crises, and improve international cooperation. The ultimate goal of the President's proposals are to create avenues to prevent the economy from approaching collapse by providing policymakers more tools to stem any significant financial ebb tide in the future.

There is no doubt that the economic situation confronting our nation, and even the entire world, is historic in magnitude and complexity and that bold action is being required for a return to normalcy. Nonetheless, there is legitimate concern that the recommendations as proffered might be too ambitious or could end up placing too much control in the hands of the Federal Reserve (Fed) and/or other regulatory entities. The plan would enhance the power of the Fed in some areas, yet take away much of its role in protecting consumers.

The key to effective regulation is to provide significant oversight to avoid the types of things we have seen recently while not stifling the innovation that is essential to progress. We never seem to get it right. Before the 1999 reforms, we were clearly too restrictive. Recently, we have not been sufficiently vigilant. Similar patterns pervade our history. The pendulum swings, but never seems to come to rest in the happy middle.

Of course, the President's sweeping overall regulatory recommendations are just the opening bell calling for an examination of the current situation to be followed by much discussion and debate regarding the best courses of action to follow. No matter how things come out, you can bet that the brainiacs will ultimately figure out ways to avoid and circumvent the best of intentions. Despite this inevitability, we have to improve the system. If the ensuing rounds lead to laws that strike the right balance between control and freedom, then new regulations could provide vital oil to the financial machinery which will eventually prove highly beneficial in enhancing the nation's financial system.

Dr. M. Ray Perryman is President and Chief Executive Officer of The Perryman Group (www.perrymangroup.com). He also serves as Institute Distinguished Professor of Economic Theory and Method at the International Institute for Advanced Studies.